Industrial software represents one of the most exciting long-term growth stories on the market. The big question is, Can it grow when industrial companies are cutting back on their spending plans? If the answer is yes, then smaller, pure-play, industrial companies like PTC (NASDAQ:PTC)Dassault Systemes (OTC:DASTY), and Aspen Technology (NASDAQ:AZPN) will be very attractive stocks in 2020. Fortunately, PTC gave results recently, and if they are anything to go by, investors should be thinking positively. Here's the lowdown.

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Industrial software companies in 2020

The largest industrial automation company in the world, Germany's industrial giant Siemens (OTC:SIEGY), gave its fourth-quarter earnings in November and pleased the industrial software world with its outlook. The company's in-house software capability makes it one of the largest industrial software companies, so when management predicted 8% growth in industrial software for 2020, the market took notice.  

Indeed, Siemens guidance has been backed up by 5% software revenue growth in the recently reported first quarter, with orders growing a whopping 33%.

It was surprising guidance for two reasons. First, Siemens' guidance for its overall digital industries segment (which includes automation equipment) was for revenue to be similar to the previous year. Second, a quick look at the leading indicators of the manufacturing sector are all indicating significant weakness. For reference, a reading below 50 in the Purchasing Manager Index (PMI), a survey of 400 executives across 19 industries, indicates a contraction in the industrial economy.

US ISM Manufacturing PMI Chart

US ISM Manufacturing PMI data by YCharts

Meanwhile, Siemens and other industrial companies aren't expecting a trough to form in their key industrial end markets before the second half of the year at the earliest. As Siemens CFO Ralf Thomas said on the earnings call, "We do not expect to see the trough in our most relevant short-cycle verticals before mid-calendar year 2020." 

Early indications are good

Returning to the question posed in the introduction, the evidence from PTC's recent first-quarter 2020 results is very positive. In a nutshell, the company raised its full-year guidance across a range of metrics after reporting 11% growth in its average recurring revenue (ARR). ARR is typically used instead of revenue as a metric for businesses shifting from a perpetual license software model to a subscription-based model. PTC's ARR rose 11% in the first quarter and management now forecasts that to increase by 14%-18% for the full year.

Metric

Current Guidance

Guidance as of October

Average recurring revenue

$1.27 billion to $1.30 billion

$1.25 billion to $1.28 billion

Revenue

$1.45 billion to $1.52 billion

$1.41 billion to $1.51 billion

Adjusted free cash flow

$260 million to $280 million

$255 million to $275 million

Non-GAAP EPS

$2.15 to $2.65

$1.95 to $2.60

Data source: PTC presentations. GAAP = generally accepted accounting principles.

The argument behind the idea that industrial software can outgrow a slowdown in overall industrial spending is based on the increasing adoption of Internet of Things solutions and the ability to improve efficiency by creating smart factories. In a nutshell, product life-cycle management (PLM) software companies like PTC, Dassault, and Siemens can help companies better manage their physical assets (automated processes and robots) by monitoring, analyzing, and modeling their behavior through web-enabled solutions such as "digital twin" technology. 

Industrial software and the economy

As PTC CEO James Heppelmann said on the earnings call, "Altogether, we're seeing more and more evidence of a rejuvenation of PLM that makes the long-term growth opportunity that much more attractive for PTC." He went on to argue that PTC was able to outgrow the economy because its shift to subscription-based revenue meant it was less susceptible to customers cutting spending than it would be under a perpetual license model.

More pertinently, he said that "we have a growth business and, as many growth businesses are, they're not cyclical, they are secular. Companies want to do digital transformation even when they're laying off workers." He concluded, "The days when PTC was highly correlated to PMI are simply behind us."

What does it all mean for investors?

Heppelmann's optimism may seem triumphal, but he's got the first-quarter numbers to back him up. Moreover, the 33% growth in software orders from Siemens in its first quarter adds confidence.

Meanwhile, Aspen Technology (an industrial software company focused on manufacturing execution systems, or MES) also reiterated its guidance for 10%-12% full-year annual spending growth in its recent second-quarter earnings report. Dassault's fourth-quarter earnings were in-line with expectations and management is forecasting 5%-10% organic new license revenue growth for 2020 with overall software sales expected to be up 22%-23.

There are definitely some signs of weakness -- Aspen saw some orders slipping and Dassault's fourth quarter was toward the low end of expectations -- , but on the whole industrial software remains a high growth area and an excellent investing theme for 2020.